Automated Bond Trading: Optimising the Opportunity

First Published 16th March 2016

For various reasons, including the diversity of securities, bonds have historically lagged other markets, such as equities and foreign exchange, when it comes to automated trading. Nevertheless, particularly in an environment being reshaped by regulation, there are growing signs that bonds will soon be catching up in the automation stakes. Simon Linwood, Head of Credit Markets and Data at MTS, and Andy Webb, Automated Trader's Co-Founder, examine the possibilities and opportunities.

Simon Linwood, Head of Credit Markets and Data, MTS

Automation of fixed income trading offers numerous opportunities
and advantages to all participants. The removal of manual
processes and paper significantly reduces frictional costs, which
in turn also lowers the entry barrier to wider participation, in
terms of both participant size and diversity. This consequently
begets better liquidity and more efficient price discovery, which
deliver more predictable trading outcomes for all.

However, attractive as this sounds, whether or not these various
benefits are realised in practice depends heavily upon the way in
which the market concerned handles the automation process. As has
been seen in some of the less successful examples of automation
in equities and foreign exchange, mistakes made in structuring a
particular trading platform and its associated processes can have
negative consequences. Toxic order flow, spoofing, activity
skewed in favour of one participant group, to name but some. The
key here is to ensure that automation of bond trading results in
an orderly market in which all participants enjoy equal
advantages on a level playing field.

The Scope of Automated Trading

Automated trading covers a number of areas of activity, some more
applicable to the buyside, some more to the sellside and some to
both. The recent BIS report - "Electronic Trading in Fixed
Income Markets1" - identified three principal
areas of automated trading activity applicable to fixed income.
In all three of these areas, given a suitably orderly and
well-managed market place, all participants could potentially
achieve appreciable and tangible benefits.

Trade execution

The use of order execution algorithms that split trades into
smaller 'child' orders has become commonplace among the buyside
in equity and FX markets and is also now present in fixed income,
increasingly in the context of multi asset trading. By reducing
market impact and by also being able to take advantage of price
improvement opportunities on each order slice, significant cost
saving and additional alpha capture become possible.

The problem for the sellside is that as buyside fixed income
algorithmic order execution continues to grow in popularity, the
costs in a non-electronic, non-automated environment become
exorbitant. Having to deal with multiple buyside child orders in
such an environment creates a major cost and efficiency issue for
the sellside in terms of manual and paper processes. By contrast,
in an automated environment, sellside participants can manage and
optimise the incoming flow electronically and use their own
execution algorithms to manage any resulting net exposure.

However, much depends upon the availability of a suitable
electronic trading environment to facilitate this process flow.
The ideal is for the sellside to have access to a carefully
managed, regulatorily compliant, electronic trading platform that
incorporates sellside and buyside environments. On the one hand,
this allows the sellside to interact efficiently with buyside
order flow, so costs are kept to the minimum and the buyside
trading experience is optimised. On the other, sellside
participants can facilitate buyside business secure in the
knowledge that they can also count on an orderly interdealer
market that offers similar certainty of execution. They can then
deploy their own execution algorithms in this interdealer market
to lay off risk in the most efficient manner possible.

However, the successful development of both buyside and sellside
execution algorithms obviously depends upon the availability of
historical data. Furthermore, such data needs to be available for
a substantive date range and, of course, be clean if it is to
facilitate the building and realistic testing of algorithms.

Andy Webb, Founder, Automated Trader

Market making

Regulation has had a major impact on fixed income market making.
For instance, it is now no longer permissible to cross-subsidise
market making with other activities, such as proprietary trading,
so market making now has to operate profitably as a business in
its own right. This, coupled with the capital cost of maintaining
inventory, has already caused some banks to switch to an
agency-only business model and/or turn away certain buyside
clients.

Automated trading has the potential to reverse this situation.
The cost of technology with which to access suitable electronic
fixed income venues has fallen, so Tier 2 banks now have a real
opportunity to participate and service their buyside clients
directly. Buyside clients that might have become non-viable, may
again become viable due to lower frictional costs and a reduced
need to maintain capital-intensive inventory.

However, for this automated business model to work successfully,
banks also need to have access to suitable electronic platforms
offering orderly markets that will allow them to lay off any
exposures resulting from buyside business with certainty. And (as
with algorithmic execution) a source of clean and reliable
historical data is also needed to facilitate building and
realistic testing of market making strategies. Finally, there is
the need for any trading platform to be able to deliver the type
of information required for regulatory compliance automatically -
for instance, best execution and transaction cost analysis.

The need for this combination of market making facilities is
becoming increasingly apparent. Market making in fixed income has
been steadily moving away from being a manual to an automated
activity for some time now. This is clearly reflected in the
migration of personnel with automated market making expertise in
FX and equities into fixed income to handle large volume vanilla
activity. This automation of less challenging flow improves
efficiency by freeing up human traders to focus on
instruments/situations that are more demanding from a market
making perspective.

However, achieving this desirable situation depends on not just
the right trading venue, but also on the quality of real time
data the associated platform can deliver.

Banks making markets in fixed income securities can benefit from
significant additional efficiencies if they have access to a
platform that can provide both interdealer and dealer-to-client
markets. The technological and cost barriers are lower,
particularly if the platform supports industry standards, such as
FIX, for both markets. Banks can thus connect a broad range of
tools that automate the trading and hedging processes, as well as
downstream and upstream activities - such as managing positions
and trading activity with clients.

Although a suitable platform is essential to facilitate
profitable market making, so too are tools that deliver certainty
of execution and price. One example might be a 'mid-price'
facility, which could enable participants to leverage automation
and take advantage of narrow spreads by trading on an average of
the bid and offer rates in a range of fixed income securities.
This would mean that buyside business could be transacted secure
in the knowledge that any resulting risk exposure could be
reliably and quickly hedged.

Directional, relative value and arbitrage
strategies

The buyside business of capturing fixed income alpha has recently
undergone a fundamental change. In the past, some of the largest
asset managers automatically benefited from price improvement, as
their banks were prepared to offer advantageous pricing through
cross-subsidy. However, activities such as crossing the spread to
oblige a major client are no longer possible as they are
forbidden by regulation. In addition, as buyside firms' trading
strategies become more sophisticated (e.g. multi asset trading),
their need for trade automation becomes ever more pressing.

This combination of buyside needs and changes driven by
regulation has seen some banks completely withdrawing from acting
as principal and only being prepared to act on an agency basis.
Some buyside clients - who have become accustomed to banks taking
the execution risks by acting as principal - are uncomfortable
with this, as they are unwilling to assume this risk themselves.

Elsewhere, some of the largest buyside firms have responded to
this change by looking for ways to trade directly amongst
themselves. However, this isn't a straightforward matter because
of the interconnectivity needed, though some peer-to-peer fixed
income venues have already emerged. Another response from some
trading venues has been to allow a mixture of buyside and
sellside participants in a single combined environment on a
relatively unmanaged basis2. However, in some cases
this has resulted in a sharp decline in average trade and quote
sizes, top of book quote sizes and quote lifetimes.

A carefully managed electronic environment, that incorporates
both sellside and buyside activity in a precisely controlled
fashion, addresses these potential issues. Access to liquidity
for the larger asset managers would be improved, while still
leaving the door open to price improvement. By the same token,
smaller asset managers would enjoy a relatively low cost of entry
in terms of technology. In both cases, strategic flexibility for
the development of more sophisticated multi asset strategies
would be enhanced.

Conclusion

The fixed income market currently has several pressing needs that
automated trading, combined with the right electronic venue,
could address. Certainty of execution and reduced costs for both
buyside and sellside are clearly major priorities. In particular,
regulatory changes have substantially increased the capital costs
to the sellside of holding inventory. Automation adds value in
the general sense here, but also in more specific ways, such as
enabling mid tier dealers to participate fully and by doing so
fill any gaps in coverage for the buyside.

Satisfying these needs also brings wider benefits to the market
as whole. Broader participation, plus the opportunity to transact
more business in a predictable manner, will also enhance overall
liquidity - both in terms of immediate sellside to buyside
opportunities and by facilitating a wider range of trading
strategies. Nevertheless, the key requirement to ensure all this
becomes a reality is a trading platform that can offer the right
combination of markets, tools and data.

1Bank for International Settlements January
2016

2 i.e. little or no constraint on "low-latency
strategies, predatory in nature, that do not appear to improve
liquidity or raise the efficiency of prices", BIS paper,
page 25.